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Executives

Jim McCluney - President and Chief Executive Officer

Jeff Benck - Chief Operating Officer

Mike Rockenbach - Chief Financial Officer

Steve Berg - Senior Vice President of Corporate Development

Analysts

Harsh Kumar - Morgan Keegan

Glenn Hanus - Needham & Company

Jason Noland - Robert W. Baird

Rajesh Ghai – ThinkEquity

Sam Wilson - JMP Securities

Min Park- Goldman Sachs

Brent Bracelin - Pacific Crest Securities

Amit Daryanani - RBC Capital Markets

Emulex Corporation (ELX) F3Q09 Earnings Call April 27, 2009 5:00 PM ET

Operator

Good day and welcome to the Emulex Corporation third quarter conference call. This call is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to the President and Chief Executive Officer, Mr. Jim McCluney. Please go ahead, sir.

Jim McCluney

Good afternoon and welcome to Emulex’s third quarter fiscal year 2009 conference call. I’m Jim McCluney, CEO and President of the company, and with me today are Jeff Benck, our COO; Mike Rockenbach, our CFO; and Steve Berg, our Senior Vice President of Corporate Development.

Mike will start off with our prepared remarks with the third quarter 2009 results, I will follow with my comments on the quarter and a discussion of our markets, and Jeff will talk about our progress on the company’s operating plan. At the conclusion of the prepared remarks I will have brief comment on the recent unsolicited acquisition proposals we receive from broad com, then we will provide some summary points and open the line for question. Over to you Mike.

Mike Rockenbach

Thanks Jim. By now, you should have Emulex’s third quarter 2009 earnings release which we issued earlier this afternoon. If you do not have a copy, the press release is available in the Investor Relations section of our website at www.emulex.com. The press release in this presentation contains forward-looking statements including but without limitation statements regarding Emulex’s business, operations and anticipated financial results for the fourth quarter of fiscal 2009 and beyond.

These statements are subject to risks and uncertainties and our actual results may differ materially from those discussed in the forward-looking statements. Those risks and uncertainties include economic conditions, market growth, IT spending patterns, changes in technology, evolving industry standard, competitive pressures, pricing pressures and fluctuations in OEM ordering pattern, the estimated total available market size, the ability to address these markets with available technology in a timely fashion, research and development activities, the inability to achieve the expected benefits from our globalization initiatives and the risks and uncertainties described in Emulex’s SEC reports filed under the Securities Exchange Act of 1934, including Forms 8-K and under the heading risk factors in Emulex’s most recently annual report on Form 10-K and quarterly reports on Form 10-Q.

We undertake no obligation to update the forward-looking statements. Investors should also be aware that Emulex will not disclose in its Q-and-A or in conversations afterwards any material financial data that was not already disclosed in its conference call or its press release.

In addition, during this call, when we use any historical non-GAAP financial measure defined by the SEC in Reg G, you will find reconciliation to the most directly comparable GAAP financial measure in our press release available on our Investor Relations website. All of the references we will make today will relate to our non-GAAP results unless stated otherwise.

Today’s conference call is being webcast and a recording will be available on the Emulex website through April 2010. I would also like to remind participants that if you decide to ask a question, it will be included in both our live transmission, as well as any future use of the recording.

Sales for the third quarter ended March 29, 2009 totaled $78.6 million, a decrease of 39% from the prior year’s quarter and a 28% sequential decline. Revenue came in at the low end of our third quarter guidance of $78 million to $85 million provided in January.

Fully diluted earnings per share for Q3 totaled $0.05, a decrease of 84% from the $0.31 reported in the third quarter of the prior year and a decrease of 78% from the $0.23 recorded in the prior quarter. Our fully diluted EPS for Q3 came at the high end of our January guidance of $0.02 to $0.05. Our third quarter results include the benefits due to the expiration of statutory limitations for our prior tax year.

Taking a look at revenue by product line, I’ll begin with our host server products or HSP, which consists primarily of Fibre Channel Host Bus Adapters for HBAs, (Inaudible) converged network adapters for CNAs, custom form factor mezzanine cards for blade servers and ASICs used in server application. HSP revenues totaled $59 million, a decline of 31% from the third quarter of last year and decline of 27% sequentially.

Revenue from board level products for the third quarter declined 31% year-over-year, representing a 22% decline in units and 17% decline in ports. Sequentially, revenues for HSP board level products decreased by 27% and units and cords decreased 24%, the ASP for board level products including standalone HBAs, CNAs and mezzanine cards declined by a modest 3% from the prior quarter.

Year-over-year, ASPs declined by 11% which is below our expected annual decline rate of 12% to 15%. Dual channel decline 25% on a sequential basis and remain relatively unchanged at approximately 50% of our Fibre Channel HBA revenues. Mezzanine cards revenues declined 26% sequentially and 1% year-over-year.

Finally, HSP ASIC revenues were down 14% sequentially and 24% year-over-year. Our second product line, embedded storage products or the ESP, encompasses SATA bridges and routers, Fibre Channel embedded SOC’s and route switches, as well as single and multi-protocol embedded controller products for enterprise class storage systems.

ESP revenues for the third quarter totaled $19.4 million, representing a decrease of 29% sequentially and 54% from the prior year’s period. As we have discussed over the past few quarters, ESP is a component business and primarily to contract manufacturers for our storage OEM customers. The combination of tighter IT budgets and an increased focus on the balance sheet across the supply chain continues to impact demand for our ESP products.

In addition, improvements in reliability and performance from lower cost SAS and SATA solutions could be driving end users to consider valued price point solutions to meet more of their storage needs. We saw these affects on ESP at the end of the second quarter and it has continued into the third quarter.

While the impact won’t be as pronounced, we do expect these trends to continue to be a drag on ESP revenues in Q4. We have provided the geographical and customer breakdown for our revenues as supplemental information in our press release.

Now, as we further discuss the income statement, I’d like to remind you that we will be primarily discussing our non-GAAP results, unless otherwise noted. You will find in our press release, a reconciliation of the difference between our GAAP and non-GAAP earnings, as well as a discussion of why we believe non-GAAP financials are a relevant measure of our business for investors.

Third quarter gross margins were 66%, compared to 65% in the December quarter. Although, gross margins improved during the third quarter, we are still seeing an impact from lower overall revenues which results in inefficiencies in our manufacturing operation.

Looking at operating expenses; during the third quarter OpEx decreased slightly to $48.2 million, compared to $48.3 million in the second quarter. Expenses increased as a percent of revenues to 61% compared to 44% in the prior quarter. I should note that the company payroll tax matching starts over again at the beginning of the calendar year, which added $1.3 million to our operating expenses.

Our current head count is 774 employees, compared to 853 at the beginning of the fiscal year and 815 at the end of the third quarter. Q3 operating income of $3.8 million was down 83% sequentially, at 5% of revenues compared to 21% in the second quarter. On the year over year basis, operating margin was down about 22 percentage points resulting from lower revenues and lower gross margins.

Other income decreased approximately 26% sequentially, coming in at $800,000 primarily due to lower interest income. With a goal of principal protection, we continue to invest in short-term government backed investments which while secure have an interest rate of approximately 1%, and we anticipate a similar level of interest income in Q4.

Third quarter net income $4.4 million, down 77% sequentially and down 83% from the prior year results. Our tax rate for the quarter was approximately 4%, which includes a benefit related to the expiration of the statute of limitations for a prior tax year. For modeling purposes, we used a 36% tax rate for our guidance in January and using this tax rate, our third quarter EPS would have been approximately $0.04 per diluted share.

Based on our current expectations, including the geographical mix of income we are expecting 41% tax rate for the fourth quarter. Our net profit margin for the quarter was 6%, which was down from 17% in the prior quarter and down from the 20% reported in the third quarter of last year.

For the third quarter on a GAAP base, we reported an operating loss of $8.4 million, a net loss of $6 million or a loss per share of $0.07. The difference between GAAP and non-GAAP income in the third quarter is primarily attributable to amortization of intangibles, stock-based compensation and severance, along with associated costs. FAS 123(R) expense reduced GAAP earnings by approximately $0.07 per diluted share this quarter.

On a GAAP basis, Q3 R&D expenditures increased 7% sequentially to $33.4 million, compared to $31.1 million in the second quarter. Quarterly R&D spending will vary depending on the timing of new product development expenses. Q3, R&D included $2.4 million of stock-based compensation.

Third quarter GAAP sales and marketing expenses were at $13.8 million, compared to $13.3 million in the second quarter. Q3 sales and marketing expenses included $1 million of stock-based compensation. Sequentially, GAAP, G&A expenses decreased 23% to $7.3 million compared to $9.5 million in the second quarter, primarily due to lower outside services expenses in general cost containment efforts.

The outside services expenses in the second quarter were primarily associated with the strategic initiatives of the company, including the starts-up of our international operations. Third quarter G&A expenses included $1.6 million of stock-based compensation.

Turning to the balance sheet; we exited the third quarter with total cash and investments of $303 million. This represents an increase of $17 million from the end of the second quarter and the increase in cash was primarily the result of lower inventory and accounts receivable levels.

Third quarter inventory levels decreased sequentially from $14.9 million, to $9.9 million and our inventory turns improved to 12.8, exceeding our target range of 8 to 10 churns. Our receivables were $49.4 million at the end of Q3, compared to $64.6 million at the end of Q2. Although our receivables came down during the quarter, our day sales outstanding or DSO’s remained higher than our historical levels, as we continued to see contract manufacturer’s focus on their balance sheet given the tight credit market and lower overall demand.

Depreciation in the third quarter increased slightly to $5.9 million, compared to $5.6 million in the second quarter and capital expenditures during Q3 decreased from $7.7 million to $5.1 million.

Before I discuss our targets for the fourth quarter of fiscal 2009, I want to again remind everyone that there are numerous risks that could affect our future performance causing actual results to differ from forward-looking statements. These risks are noted in our public filing with the SEC and the Safe Harbor statement at the end of our earnings press release. As a result of these risks and uncertainties, we are unable to predict with accuracy what future corporate results might be, and there is no guarantee that business will reach our expectations or goals.

Based upon current market conditions, our customer’s public comments and their most recent forecasts we believe that revenue for the fourth quarter ending June 28, 2009, could amount to approximately $73 million to $80 million. The midpoint of our guidance is down slightly from our third quarter results and represents a decrease of 29% to 35% from the fourth quarter of 2008.

While we don’t give specific guidance by product line, I want to provide a little color on trends we are seeing in the business. In our ESP products, we expect the trend towards lower cost SAS and SATA based storage at the expense of Fibre Channel based systems will continue.

In addition, an end of life plan at one of our customers will result in lower revenues from our InSpeed route switches which have significantly higher ASP’s than our ASIC’s. Consequently, we expect ESP revenues will remain soft in Q4. Conversely, we are seeing some stability in HBA’s and mezz cards. While it’s probably too early to declare a bottom, we are modeling for a flat to slightly up fourth quarter for HSP. If we achieve revenues in this range, we anticipate non-GAAP earnings per diluted share of $0.01 to $0.05, assuming a 41% tax rate.

I’d now like to turn the call over to Jim, who will give you more color on the quarter and then an update on the company’s strategy.

Jim McCluney

Overall, Emulex and its employees executed soundly during Q3. We delivered on our guidance in the midst of a very challenging economic environment. As Mike mentioned, we reported revenue of $78.6 million for our third fiscal quarter at the bottom end of our range.

Our Host Server products were down 27% from the December quarter, at $59 million and our Embedded Storage products were down 29% sequentially to $19.4 million. Non-GAAP EPS of $0.05 was at the top of our range and above consensus. The Host Server business met the expectations we had going into the quarter.

January was slow, however February and March each improved. HSP business at the OEM’s is starting to show signs of leveling out. While there are some portions of the business that are better overall, there are still some challenges. Obviously, broad economic issues, that are affecting our major server and storage OEM customers which in turn impacted us.

Other issues affecting business in the quarter included our transition to Intel’s new processors, which delayed some 8 gig launches, as well as the continuing shift of the HBA business from storage OEM’s to server OEM’s, as were talked about in prior calls. It is our belief that the market for Host Server based products may be flattening out as we move into the June quarter. The embedded storage business however, continues to have challenges.

As Mike just mentioned, we are managing an end of life process, route swatches of a key customer which is contributing to our downward trend in revenue. Additionally, SOC’s are tied to high performance storage which has been impacted by budget reductions driving IT managers to spend more on entry level stacker based storage.

So, while we are starting to see business contractions slowing, we could still be a quarter or so away from ESP leveling out and returning to growth. Despite the challenges, I remain confident in the future prospects of our ESP business, particularly as we start to provide tier one storage OEM’s with board level products.

Looking forward, for the macro business sentiment appears to be improving a little. Out of abundance of caution, we are managing the business as a whole, with expectations that the environment will not be improving in a meaningful way for several more quarters.

Having said that, the level of inbound customer inquiry to Emulex has never been higher and we sense a more optimistic outlook for the future. In the meantime, we’re successfully meeting our challenges and executing our strategic vision, which is the next topic I’d like to comment on.

The cornerstone of our strategy is the converged data center, based on 10 gig Ethernet technology. Our converged data center network is one that unifies IP and storage networking over a single wire. Our converged network translates into less complexity, less infrastructure, reduced cabling, lower power consumption and simpler management. On February 18, at the New York Stock Exchange, Emulex announced its game changing strategic vision for network convergence.

At our launch, even some of our leading OEM customers and industry partners, including BNT, Cisco, Dell, EMC, Juniper, Microsoft, RSA and VMware, contributed to the announcement. Our network convergence strategy is based on OneConnect, our revolutionary 10 gigabit Ethernet universal converged network adapter or UCNA platform, on OneCommand, the convergence management framework.

These products represent a fundamentally new direction and opportunity for Emulex and our strategy has been applauded by industry peers, analysts, partners and customers alike. We recognized early on, that for this new convergence market, producing simple extensions of either the Ethernet NIC or Fibre Channel HBA, would not deliver on the requirements and demands of our OEM’s and data center users. That is why we created the OneConnect UCNA platform, the industry’s only universal CNA.

OneConnect uses our VEngine technology to make servers more efficient, with lower power and cooling costs and maximizes the benefits of server virtualization and data center consolidation. To be the leader in this new market, Emulex understood that our OEM’s and data center customers needed a new and innovative connectivity infrastructure that preserved their current investments, positioned them for the converged future, leveraging the ubiquity of Ethernet and providing the low latency and high performance of Fibre Channel.

We believe Emulex is the only company to make the transition to a fully offloaded Ethernet driven network convergence product family, with a complete array of enterprise proven drivers, management and intelligence services. Upon seeing the level of engagement Emulex is having with OEM’s, we have noticed that a number of our competitors have struggled to put together the technology to compete with this strategy, but that hasn’t stopped them from emulating our messaging.

It takes a unique set of technologies to execute this strategy and we’re flattered that competitors recognize that our solution set is at the forefront of customer’s requirements. In fact, during a recent survey of Fortune 500 data center IT managers, by IT Brand Pulse, Emulex was recognized as the overall marketing leader in the converged network space. We know that this strategy and set of technology solutions is putting the spotlight on us because we have an unprecedented level of customer engagement and design activity.

Jeff, will provide more details on our significant design wins at tier one OEM’s based on the strength of this portfolio. By delivering on this strategy, Emulex has doubled its addressable market, beyond traditional Fibre Channel and has expanded into new product categories that have significantly increased our strategic value to OEM’s. Our leadership in converged networks does not mean we are taking our eye off the rest of our Fibre Channel portfolio. We have ongoing commitment to Fibre Channel and we recently announced the industry’s first 8 gig encryption HBA.

In addition, we continue to invest in 16 gig Fibre Channel. On the embedded side, we see increasing demand for bridging products and there are other opportunities to support the transition of solid state drives in the enterprise. We’re also seeing an increasing demand from our storage OEM customers to leverage our systems expertise and provide board level products, instead of the traditional ASIC solutions. Executing on these opportunities is the key to accelerating our ESP revenue growth.

With that, I would like to turn over to Jeff, for more of the details on our operations and specifics of our strategy; over to you, Jeff.

Jeff Benck

Thanks Jim. Let me start with a review of operation during the quarter and then I will spend some time on our progress on the strategic front. From an operational standpoint, the company performed very well in the third quarter. We reduced our product costs, brought our inventory down sequentially by an additional $5 million, improved our inventory turns to nearly 13 and saw marked improvement in the elimination of excess in obsolete product.

Even though our revenue trended to the low end of our guidance, this performance along with tight expense control and lower reported tax rate allowed us to achieve the high end of our EPS target for the quarter.

We’ve been on a continuing mission to reduce expenses and we have asked employees to treat each expense as if it was coming out of their own pocket. With revenue down sequentially, everyone has contributed and helped us bring expenses down and what would typically be a higher expense quarter. In addition, we asked employees to understand our need to reduce some benefits as well.

Of course, we tried to limit travel too, but our growing set of customer engagements did not allow us to save as much on that line item. However, we made up for it in other areas. Besides the aforementioned discretionary cost savings, we again made some tough choices on reducing our overall headcount.

We took an action in late March that impacted 43 employees. We know have 774 employees on board, which is reduction of over 9% from the beginning of the fiscal year. While headcount reductions are always difficult, our focus on reducing layers of management, upgrading key roles and prioritizing objectives has served to make Emulex, a more nimble competitor in the market place.

For the third consecutive quarter, we have bought operating expenses down and that trend will continue. On a annualize basis, we will have brought our expense down approximately $20 million or about 10% year-over-year. As I said earlier, we remain highly focused on execution even as we have cut expense.

I am proud to report that we’ve managed through these changes without disrupting our roadmaps, customers or performance in the quarter. At the same time that we have reduced expenses, we’ve been able to increase on investment in areas such as building brand preference, global expansion, building vertical market expertise and winning new customers. To this end we now have several new competitive initiatives in place to help Emulex drive share gains in the marketplace.

On our last call, I outlined some of the key organizational changes in both sales and marketing groups. Jeff Hoogenboom, our new SVP of sales and Steve Daheb, our CMO, have revamped our go to market strategy and increased our market presence. We have continued international expansion EMEA and Asia Pacific to reach faster going markets and the company completed a very successful strategic launch in February tied to our 30, anniversary.

As Jim mentioned, we announced our OneConnect Universal CNA, our 8 gig encryption Fibre Channel HBA and our new software management framework for converged network environments OneConnect. Furthermore, we are improving our scale and ability to tough more customers and partners with the focus on e-marketing, our new corporate website, OEM driven microsites and our aggressive use of social networking.

Now, I would like to spend some time discussing our progress with our product strategy for our two core product lines. Starting with ESP, we are progressing well on our systems and solution storage platform design wins. These add depth and stickiness to our storage customer engagements and represent an opportunity to drive incremental revenue growth.

Also this quarter, the ESP team closed two tier one bridge wins that included our new SAS to SATA bridge technology, which is seeded in the suite spot of the storage market. These products allow us smooth transition in the new technology, while maximizing performance.

Turning to HSP, we kicked up the quarter with a new report from the Dell'Oro Group confirming Emulex gained three points in Fibre Channel HBA market share in the fourth calendar quarter of 2008. In March quarter, we also launched a number of new 8 gig Fibre Channel offerings with key OEMs including HP, Dell, EMC and Fujitsu Siemens, among others.

We continued to deliver in the strategic blade server market by completing qualifications and beginning shipments of 8 gig mezzanine HBAs for the latest Intel Nehalem blades for the Dell and HP. In fact, we are currently the only company shipping 8 gig Fibre Channel mezzanine and standard PCI adapters to the new Dell PowerEdge 11G servers.

Emulex now has full coverage for 8 gig HBA’s and mezzanine cards across all of the leading server and storage OEM’s. These continued investments in our core Fibre Channel market, is being leveraged into our network convergence strategy, as we share many common technologies, drivers and interoperability efforts. We believe converged networking is the next inflection point in network I/O and Emulex is well positioned for this transition.

Our strategy in this hot area was built by listening closely to customers and then creating a new business model, establishing the right technology partnerships and executing a comprehensive product strategy that provides unmatched flexibility and customer value. Our new UCNA products enable us to participate in 10 gig network interface cards, 10 gig iSCSI adapters and 10 gig FCoE CNA’s in both mezzanine and stand-up PCI form factors.

OEM’s are looking for the next generation networking vendors to provide a complete portfolio of solutions for their converged I/O requirements, providing a one-stop shop for all of their I/O needs. Our OEM clients are telling us through the award of design wins and development engagements, that our product strategy is hitting the mark and beating the competition.

Many investors may be surprised to find out that our OneConnect UCNA wins are based as much on our 10 gig Ethernet performance and capabilities, as our proven Fibre Channel over ethernet software stack. To provide some perspective on our momentum, we currently have 16 unique 10 gig Ethernet based OEM card designs in flight and we have already been awarded five tier one 10 gig NIC placements, there 10 gig iSCSI CNA placements and four 10 gig Fibre Channel over Ethernet CNA placements.

Our Ethernet centric convergent strategy is winning business away from traditional Ethernet NIC suppliers and locking out storage networking competitors that do not provide a complete portfolio of UCNA solutions. To accomplish this, we uniquely matched the high performance 10 gig Ethernet engine with our battle hardened enterprise software stack to create a product that balances Ethernet strength with our Fibre Channel heritage.

The primary difference between Emulex UCNA’s and competitive CNA’s is our ability to offload and support all three I/O protocol versus just one for our competitors CNA’s. This competitive advantage enabled Emulex to provide unparalleled customer choice, while maximizing I/O performance, server virtualization and data center consolidation.

In addition to the solid progress last quarter of our OneConnect UCNA strategy, we were pleased to start shipping our first CNA blade for Cisco’s recently announced Unified Computing System.

Let me conclude by emphasizing, again, what we think is the most important point we made today about our business. Emulex has made the transition from a Fibre Channel storage company, to a converged networking company. This is important for people to understand, especially, those who may be new to our company and tuning into our call for the first time.

Our industry leading technology is winning 10 gig NIC, iSCSI and Fibre Channel over the Ethernet qualifications over both traditional Ethernet NIC and Fibre Channel storage networking providers. We have significant new opportunities that are driving a high level of attention from customers and grudging respect from our competitors. We have a winning strategy, we are executing that strategy and we are building a next generation network convergence company.

Jim McCluney

Okay. Thanks, Jeff. That was great. Thank you. Before I summarize, I’d like to make a few remarks about the unsolicited acquisition proposal we received from Broadcom on April, 21. Consistent with our fiduciary duties, the Board of Directors is conducting a thorough process to review the proposal with the assistance of our advisors.

It’s premature, at this point, to speculate on when that review process will conclude and what conclusion the board will reach. As such, we are not going to discuss or entertain questions on the proposal on this call today. As the board conducts their review process however, the rest of the organization is laser focused on continuing to execute our company strategy and meeting our customers’ needs.

As you have heard, we’ve been pleased with our momentum and new customer design wins. While we’re not in a position to announce the details of these wins, as customers require confidentiality, we believe some of them have come at the expense of our leading competitors, including Broadcom and will have significant positive impact beyond the next few quarters.

We expect this momentum to continue and believe it, along with the interest we have received from Broadcom, underscores that our fundamental strategy of approaching network convergence from an Ethernet centric model versus a storage extension model; is driving significant volume and enabling Emulex to capture the leadership position in this important and rapidly growing market. So let me conclude with some key summary points.

I’m very pleased with our overall execution during the March quarter. In addition to meeting our revenue and earnings targets, our focus on controllable expenses and maintaining a strong balance sheet resulted in lower inventories, lower accounts receivable and an increase to our cash balances by $17 million to over $300 million during the quarter.

The June quarter guidance of $73 million to $80 million in revenue and $0.01 to $0.05 in diluted EPS is reflective of the fact that we are at or near a bottom. We will continue to tightly manage expenses to run an efficient and profitable business, while delivering on our future. Our UCNA strategy is really paying off. We have doubled our addressable market and are already starting to rack up the design wins necessary to capture that opportunity. We believe that many of our recent customer design wins, while not public, will put the company in a very strong position for the future.

That concludes our prepared remarks, so with that, we have time to take questions. Operator, please go ahead and open the line.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Harsh Kumar - Morgan Keegan.

Harsh Kumar - Morgan Keegan

Guys a couple of questions, a strategic question, we’ve seen a lot of technologies that look great, sound great, but simply don’t get adopted by businesses or take forever to get adopted. What is your viewpoint of the converged market at this point as it stands? In this battle, I guess question for Jim, who do you think wins out? Do you think the Ethernet guys win out or do you think the Fibre Channel guys win out for control of this market?

Jim McCluney

This is Jim, here. I think we’ve seen an unprecedented level of interest in this convergence. I think it appeals to all the things that IT Managers are looking at, saving costs, reducing power. There’s no record and replace on the I/O. We can preserve their management environments.

So, it remains to be seen in the current economic climate, how the adoption goes, but I think the first key thing is for us is: are our key OEM’s adopting it? They are. They are looking to implement these in their next-generation products; and your question about Ethernet versus Fibre Channel storage.

We did take the view that we have been messaging this for many, many quarters now, the Ethernet was going to be the transport of choice here and that’s why we deliberately looked at providing all the spigots necessary to connect your storage, whether that’s through FCoE or iSCSI or if you want to run this as a standard NIC.

We said, let’s give the customer a choice of how they want to deploy this, and I think the most critical thing was that we could provide the hardened Fibre Channel drivers on top of it. That’s where I think the people with those Fibre Channel drivers are in a really good position, as long as with the long class Ethernet stacked behind it as well.

Harsh Kumar - Morgan Keegan

That’s actually very helpful, Jim if I can slide in one more and get back in queue like everybody else. What are you guys thinking of in terms of timing for these, I know you’re putting them out, but in terms of adoption of the end market? Also, if you could talk about maybe the growth prospects of your two businesses, not near term, but let’s just say, the next two to three years for the HSP and the embedded business, please?

Jim McCluney

So, as far as adoption of the converged network products, you’ll start to see our next generation products roll out this fall. We’re already shipping some converged network adapter products today. As we mentioned, we’re in market with the first generation technology. So, you’ll start to see OEM’s start to deliver the next generation as we go through the second half of the year.

Mike Rockenbach

Yes, in terms of growth. I think you can see in our guidance, we’re looking for the business to be relatively flat this quarter. There’s a combination of a couple of moving parts. In the next quarter, we’re going to be seeing continued transition, really towards more of the price performance SAS and SATA drives.

I think that really kind of plays into some of the new designs that we’re working with OEM’s on launching, getting them quals over the next quarter or so and have those drive more growth on the ESP side.

In terms of the host server products, I think near term the opportunities for us are to continue to execute well in terms of the emerging markets with 4 gig and as we go in to the next couple of quarters, we’re expecting that the OEM’s are going to start launching and moving forward with the 8 gig solutions and then, ultimately further on down the road, it’ll be rolling out to quals on the CNA’s.

Operator

Your next question comes from Glenn Hanus - Needham & Company.

Glenn Hanus - Needham & Company

Good afternoon. Maybe you could elaborate on the encryption HBA’s, whether that’s a meaningful opportunity for you or just sort of a little bit of supplemental revenue on the side?

Jeff Benck

Could you repeat the second pat part of the question, I heard you ask about…

Glenn Hanus - Needham & Company

Just a general question about the significance of the revenue opportunity with the encryption HBA’s, is that a separate category from just 8 gig HBA’s, the encryption aspect?

Jeff Benck

Yes, this is a different product. Pretty excited about this because we have the ability to encrypt the data as it leaves the source at the server, both in flight and at rest and we think that’s a little differentiated from doing it in the fabric or in the switches.

We’ve seen some good interest in the marketplace, not only from end users that more and more want to drive security into their solutions, but also several OEM’s have expressed some pretty good interest for it.

Encryption is a little hard to predict. There’s not good industry data on how fast that will take off. We know that with all the threats out there for people’s data and the more people are storing, it’s something that is top of mind for a lot of our customers.

We do have lead hero customers, we’d say, they want to bring the technology to market. Obviously, we’re not at the point to share that yet, but we do see this as an incremental opportunity over our standard 8 gig Fibre Channel HBA products.

Glenn Hanus - Needham & Company

Maybe you could talk about how you feel you’re doing in better sales force alignment to the shift in end markets on the HBA side and how far you’ve come and what work remains?

Jeff Benck

We talked a little bit about it in the prepared remarks, but we, it’s obviously a little sensitive because there’s competitive elements to it, but we have brought some new leadership on in both sales and marketing.

We have looked at our alignment of our resource, both with the OEM’s, as well as in the channel. We’re also looking even within the channel at distributors versus VARs and second tier resellers then where is the right place to put emphasis on our sales organization.

We also have been taking more solutions to market. So it’s important to have the alignment in the verticals, because that’s how our OEMs go to market. So, those are some focus areas for us along with the emerging geographies.

We’ve talked about putting more people in the emerging geos as the key growth, particularly, in times where, the U.S. economy has slowed down, some of those emerging areas, even at the slower rate, are still growing faster.

So, we’re pretty focused on that. Don’t want to get too much in to specifics, but those are some the areas we are looking at. We are doing some upgrades of the talent and improving our capabilities, at the same time that we shift some resource around.

Glenn Hanus - Needham & Company

Lastly maybe, Mike, could you give us a feel for operating expenses over the next few quarters? How much might you be taking out of the OpEx line, sequentially, each quarter?

Mike Rockenbach

Yes, Glenn, that’s a good question. I think, as we go into the next couple of quarters, there is a couple of things going on. In the fourth quarter, I think we’ll see a benefit from the reductions we made, right at the beginning of the quarter.

So, we should see that having some favorable impact in Q4 and then, as we go into the back half of the calendar year, I think you kind of have the opposite affect of what we saw in the March quarter, where payroll taxes, company match starts over at the beginning of the year and then, that added $1.3 million to the expenses.

As we get in to the September and December quarter, employees start maxing out and, so that matching declines overtime and then of course we’re going to continue to focus on a balance between really managing our controllable expenses, discretionary expenses like travel and things like that, but continue to really focus in on the opportunities that we’re seeing on the R&D side.

I think, as we talked about in our prepared remarks, when you look at us in Q4 versus a year ago, expenses are going to be down about 10%, kind of an annualized basis, that’s about $20 million a year that we’ve taken out of our run rate of expenses.

So, very focused on continuing to look at where the opportunities are, investing where we can really exploit opportunities and make a difference, but certainly, being responsible in terms of how we manage our expenses.

Operator

Your next question comes from Jason Noland - Robert W. Baird.

Jason Noland - Robert W. Baird

Thank you. Jim, first question, Ethernet vendors have been looking at the CNA market for awhile and seem to be headed down the build route versus the buy route I guess, is it your impression if they ran in to technical hurdles or what’s happened?

Jim McCluney

Well, I can’t comment really on what they’re doing. I think that the critical thing is that, when you look at the traction that we’ve been getting with our solution, it’s offering everything they’re looking for, battle hardened drivers on either side, good software suite and support.

It’s not all about hardware, as we know by the line share of our engineers inside Emulex are doing drivers and software and filmware, so, that was our focus, as I’ve said you need rock solid Ethernet and you need to build on that.

Everything people have come to expect from the Fibre Channel stock, as well and we’ve built that into our FCoE remodel. So, I think there were some early thinking around maybe doing FCoE in software on a hardware platform but I think people have been looking more for the level of performance offload that they’re used to seeing. So, I hope that answers your question.

Jason Noland - Robert W. Baird

Just a follow up to that, do you have what you need in 10 gig E or would a small acquisition would that make sense?

Jim McCluney

No, we’ll go where we need I mean the technology and products that were presented to our OEM base is delighting them and I think that’s witness to the validation of the design wins are the things that count, Jason and that’s a testament to the technology and products we have, so I think we’re sitting here as best of breed.

Jason Noland - Robert W. Baird

Okay last question from me. Mike, with some of this cost down initiatives and then innovation projects, is it fair to assume that in fiscal 2010, we could see SG&A come down in absolute dollars but R&D go up in absolute dollars?

Mike Rockenbach

Our intent is that I think on a year-over-year basis, you’re going to see really all of the operating expense lines coming down. Clearly, we’re going to focus on making R&D investments where we’re going to get the most leverage and return on that investment.

In terms of sales and marketing, it probably comes down less in absolute dollars than G&A because we are realigning where we’re making sales and marketing investments, but I think as we get through it, when we look at FY ‘10, our expectation and what we’re driving to is each one of the operating expense lines is going to be down year-over-year, as we focused on our expenses.

Operator

Your next question comes from Rajesh Ghai - ThinkEquity.

Rajesh Ghai – ThinkEquity

I had a question on the Brocade’s entry into the HBA market. It’s been a year since they entered the market. Have you begun seeing any impact in and as far as pricing, as far as market share in the recent quarter?

Jeff Benck

Yes, this is Jeff. Obviously, we’ve seen that Brocade has gotten some quals in process. We haven’t seen a lot of end user adoption of course, they’re making noise in the market, but when you look at real placements we haven’t seen it.

As far as pricing goes, nothing out of the ordinary, it’s a competitive market, there are multiple players in the market and there’s been the normal back and forth that you’d see there, but nothing that would be alarming for our business.

Rajesh Ghai - Think Equity

Okay and in terms of the Broadcom offer, I’m not going to ask you a question on the offer, but do you see any potential disruption in terms of your design qualification process if this thing drags on?

Jim McCluney

No, we haven’t seen any disruption. In fact, we’re still getting design wins coming in.

Rajesh Ghai - Think Equity

Okay and in talking on the ESP business decline, there has been obviously an ESP decline because of the product and the mix shift towards cheaper storage. I was just wondering when do you see this business kind of stabilizing. I believed you did see the HBA business stabilize to some extent. Do you see some inventory restocking beginning to occur in the month of April or are you still kind of seeing the trend that you saw early in the previous quarter?

Jeff Benck

We do see in terms of how we modeled for the June quarter that I think we don’t expect to see as pronounced a decline in ESP as we saw in March, but we are going to see one of our OEM’s in end of living one of their route switches.

So, I think if you kind of took that out of the equation, ESP is probably relatively flat in the June quarter so, we’ll have to see where we end up as we get in to the summertime, but we are focused on launching a couple of new designs that are focused in that SATA market, rolling out into the end of the calendar year.

So, that’s again, kind of similar to HSP, we’re probably not going to be at the bottom in the March quarter. We do see a little bit more decline in June, but I think as we get beyond that, we are going to start to see things stabilize and ramp up, in particular, as the new design wins start to ramp on late this calendar year.

Rajesh Ghai - Think Equity

Okay and one last question, I did see that the contribution of revenues from OEM was up and consequently, the revenues from distribution was down and anything you can say as to what’s going on over there?

Jeff Benck

Yes, I think we’ve kind of talked about it a little bit over the last, maybe a year or so is, particularly, this business is or this transition is being driven by the growth in blade servers. Blade servers are going to be more OEM centric business and so, we’re seeing a shift away from the distribution side as those cards are being integrated at the factory. So, I think that’s kind of an influence that we’ve seen going on in the business for the last year or so and we probably expect that trend be continue over the next few quarters, as well.

Operator

Your next question comes from Sam Wilson - JMP Securities.

Sam Wilson - JMP Securities

A couple of just small questions first, if you look at the 8 gig ramp so far and you compare it to the 4 gig ramp of a few years ago. Can you give us a sense timing, speed-wise how it’s been rolling out relative to 4 gig? Is it slower because of the economic, etc.?

Jeff Benck

It has been rolling out slower. It’s, I guess we could speculate and say some of it is probably due to kind of the economic environment. 4 gig was a really fast transition. I think you had a couple of things driving it, maybe most importantly, was server architectures were moving up to PCI Express. So you really got the full benefit of the doubling the bandwidth on the length side, by taking advantage of the new Bus architectures, as well.

Mike Rockenbach

RoHS too.

Jeff Benck

Yes, and you had some other things going on in terms of the broader market. With 8 gig, kind of one of the challenges is the optics in 8 gig are adding a little bit of a premium, compared to 4 gig, at least on the initial volume. So, I think that’s kind of a combination of two things, you have a very fast transition with 4 gig, with some other things influencing that transition.

Conversely, you’ve got some economic challenges this quarter or this year and in particular, a big driver of new technology has been the financial vertical. They’re the ones that have a lot of I/Os; a lot of throughput and so, as you’ve seen a lot of disruption in the financial institution, I think that’s probably a combination of a few things that have driven 8 gig to be a much slower launch.

In terms of ramping up and for us, it’s just probably a little bit under 10% of our overall board revenues this quarter, but from a design win activity standpoint, from a quals standpoint, the OEM’s have continued to drive forward.

I just think from an end users perspective, the up-tick has started out slower, but we expect as we go towards the end of the calendar year, that more launches are going to be done by the OEM’s and that’s going to continue to ramp up.

Sam Wilson - JMP Securities

Asia relatively outperformed EMEA and U.S. and I was just wondering, it just may be coincidence, was there any color or characterization that you have about why Asia was doing relatively better?

Jeff Benck

Well, in terms of how we report revenue, it’s based on where we ship it to. So, that isn’t necessarily going to be where the end products end up, but we do have a lot of activities with our customers moving their manufacturing to the Asia market and like I said, it’s kind of difficult for us to tell from our side exactly where are those systems being deployed.

But in looking at some of the comments and commentary by our customers on their announcements over the last few weeks, I think certainly, a slow environment globally, but some of the emerging markets that were expected to be growth areas are still growth areas, they’re just not growing as fast as previously modeled. So, I think that’s a similar trend to what we’re seeing in our business as well.

Sam Wilson - JMP Securities

The last two questions very small. Cash from operations for the quarter and did you buy back any stock?

Jeff Benck

We did not buy back any stock and we increased our cash balances by about $17 million, so we’ve got a little bit over $300 million now.

Sam Wilson - JMP Securities

Right, but do you have cash from operations from the cash flow statement?

Jeff Benck

I don’t have it in front of me, but we’re probably going to file our 10-Q tomorrow, so you should be able to pick it up in there.

Operator

Your next question comes from Min Park - Goldman Sachs.

Min Park- Goldman Sachs

Can you just give us your sense of how the overall market for HBA’s performed in the quarter and to what extent do you think you gained or lost share in the period, either by poor account or by revenue?

Jeff Benck

I think when you look at; we came off with last quarter and gained quite a bit of share. As we look at the current quarter, we think we performed well with the OEM’s. It’s a little bit tough to tell without seeing QLogic’s earnings later this week to know, how our chief competitor did there.

We think we’re really well positioned for the 8 gig transition; we really talked about the support across the range. In fact, in some cases, we’re better positioned as in Dell, where we’re the only one shipping 8 gig products today and then, we’ve got a number of new CNA wins that should bode well for us from a competitive standpoint.

Min Park- Goldman Sachs

Then on your comment that February and March was a bit better than the month of January, is that improvement on a sequential basis or did you actually see year-over-year performance improve in each of the latter two months?

Jeff Benck

We were looking at it more on a sequential basis.

Min Park- Goldman Sachs

On a year-over-year basis, can you tell us if March and February were better than last quarter?

Jeff Benck

Given the amount that we were down year-over-year, I’d say it’s probably unlikely, but I didn’t look at it.

Operator

Your next question comes from Brent Bracelin - Pacific Crest Securities.

Brent Bracelin - Pacific Crest Securities

I had a follow up question on the design win opportunities you guys are going after. As you think about these next-gen server designs, are you kind of bidding on opportunities that will include a 10 gig NIC and Fibre Channel software drivers and I/O offload or you bidding on opportunities just to provide the Fibre Channel I/O offload on a chip. Just trying to better understand the opportunities you guys are going after?

Jeff Benck

No, I think it’s one of the key distinctions we were trying to describe in today’s call. We are absolutely participating not only in the storage networking element with Fibre Channel over Ethernet, but also in 10 gig NICs and iSCSI adapters, which frankly is a kind a Greenfield for us because that’s incremental opportunities.

I think what’s a bit different is, we have 16 different designs, in unique designs in flight. That’s like three times or many as many as we had a year and a half ago based on only doing Fibre Channel-based technology.

So, if you look at, what I described in my remarks. We already have five tier one 10 gig NIC wins, which is just for the 10 gig Ethernet network interface card and three 10 gig iSCSI, CNA wins, which is really iSCSI offloaded that fully offloaded.

iSCSI, not just software initiator and then a number of 10 gig NIC, four 10 gig, FCoE CNA placements, which you might have expected from us because of our strength in the storage networking side of the house.

I think, just adding a little bit to some of the color that Jim provided earlier, who is going to win in this space, whether it would be the Ethernet guys of the stores, networking guys. I think, we would say probably neither, we think that you have to provide a solution that encompasses both the Ethernet element, as well as the Fibre Channel storage capability.

So, if anyone comes that the space with just one part of the solution, then I don’t think there will be affected in the marketplace going forward because, what customers were expecting in the support for multiple protocols and the offload and the software resiliency around that.

Brent Bracelin - Pacific Crest Securities

Just a follow up on that 10 GigE design wins, you talked about those are for add-on cards or is that actually 10 GigE chips on the motherboard?

Jeff Benck

That's for adapter option cards.

Brent Bracelin - Pacific Crest Securities

As you think about the gross margin applications in 10 GigE, if I would look at the 10 GigE suppliers, they have meaningfully lower gross margins than you guys do. How should we think about the ramp of 10 GigE and the impact on your margins?

Mike Rockenbach

A lot of these opportunities are in flight right now, as Jeff said. We’re looking to start shipping some later this calendar year and more meaningfully into next calendar year, but I think you’re absolutely right.

One of the things you see in the Ethernet world is that it does have lower gross margins, but also has significantly higher volumes and as we kind of talk about in our prepared remarks, this is the different model for us.

We know it’s a different model, we’re going to drive our business to be successful in that model and that includes, not only being successful in the board business for NICs and iSCSI, but also some opportunities in terms of expanding the software aspect about our business, as we go after not, only our traditionally markets, but incremental markets.

Jim McCluney

Yes, just add to what Mike said. If you look at over the horizon, we really like the look of the potentially revenue growth there and we’re just going to adjust the business models to different percentage plus models that probably include gross margin dollars and so, it's obviously a very attractive market, as I said in the prepared remarks, it literally doubles our addressable market. So, I think we have time for another questions, so Mike, what do you think?

Operator

Your last question comes from Amit Daryanani - RBC Capital Markets.

Amit Daryanani - RBC Capital Markets

Just a couple of quick questions for you guys. One, on the inventory side, you guys did a pretty good job managing the inventory dollars down 30%. Can you maintain these levels in the June quarter or would you have rebuilt some buffer inventory through the June quarter?

Jeff Benck

No, I think we're in a pretty good position to be able to hold our levels of inventory down. We have been doing a lot on the operations side over the last couple of years, quite frankly, to drive down our component costs, improve our gross margin, improve our inventory churn and improve our fulfillment and that cover as bunch of different things. That covers not only things we've done to consolidate our contract manufacturers, but also launching our distribution center in Ireland a quarter or so ago.

So I imagine, as we talked about, we're up above our target range. 8 to 10 churns is our target range. So, having them up pretty close to 13 churns is a little bit high. So, we might see that comedown a little bit, but I think we’re pretty comfortable that we can manage our inventories towards the higher end at least about a 8 to 10 churns.

Amit Daryanani - RBC Capital Markets

You mentioned, I think the Emulex Board and the advisors are evaluating Broadcom’s offer. Is there a timeline that we should be cognizant about? At this time, do guys would come up with a reply?

Jim McCluney

No, we’re going to comment on that as I said on the call, that the Board takes the duties to the shareholders very seriously and undergoing a federal review process, consistent with those duties and we’ll make a public announcement as soon as we are in a position to do so.

Operator

Thank you. Mr. Rockenbach, I will turn things back over to you.

Mike Rockenbach

Well, thank you, everyone, for joining us on our conference call to discuss Emulex third quarter results for 2009. Look forward to talking to you again as we report our fourth quarter numbers, our in August and I hope you all have a good evening.

Operator

That does conclude today’s conference. Thank you for your attendance and have a nice day.

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